- The recent share price increase is likely to hit a roadblock while credit concerns are resolved.
- The fourth quarter showed a sizable, criticized loan increase without a matching reserve build.
- The stock is currently at a warranted discount to peers, but trading at above tangible book value.
While most banking institutions typically consist of two parts, a holding company and bank subsidiary, Warsaw, New York-based Financial Institutions (NASDAQ:FISI) bucks the typical structure trend. FISI is actually a holding company with four different subsidiaries: Five Star Bank, SDN, Courier Capital and HNP Capital. The largest financial driver to the overall company, Five Star Bank is the retail and commercial banking unit that most people generally know and understand. SDN is the unit in which insurance products are sold. Finally, Courier Capital and HNP Capital are more focused on investment management, with a wide-ranging client list of individuals, businesses, and institutions.
With branches dotting the map in nearly every western New York town, FISI has a unique geographic footprint that should continue to drive balance sheet growth and improve financial leverage. With that being said, its recent credit woes juxtaposed against its sizable stock price increase gives me some pause to overall investment.
On a very fundamental basis, I believe FISI is operating well and generates a healthy amount of profit for shareholders. Over the long term, this bank is likely geared to continue to improve its efficiency ratio, which could spill over and generate a higher dividend payment. That being said, its recent credit deterioration (via massive, criticized loan increases) keeps me on the sidelines.
With the tangible common book value per share increasing to $23.52 in the fourth quarter, the bank currently trades at ~1.15x P/TBVPS. While this is below the peer average of 1.35x, I believe the current discount to peers is warranted given the sizable fourth quarter increase in criticized loans. While the loan loss reserve has increased, it is slightly below peer like levels. In my mind, the bank is very likely to survive, but I do believe that it is likely to face a couple of difficult quarters in order to shore up the balance sheet. While I do not recommend the bank of an equity appreciate focused investors, a strictly income oriented investment could be warranted due to the outsized dividend yield.
Based on the two charts below, investors are likely to have mixed feelings about FISI and its long-term underwriting standards. On one hand, FISI has proven itself to be a solid underwriter through the last financial downturn. On the other hand, as one can see from the second chart, criticized loans have skyrocketed higher - the main thesis to my natural rating.
When looking back, Net charge-offs ("NCOs") were handily less than peer like levels through the thick of the Financial Crisis. However, they continued to be elevated, on the relative basis, when other banks had clearly turned the page (2013-2019).
In my mind, this level of consistency is more likely to be rewarded rather than punished, simply due to the consistency of financial and credit results. It's much easier to model consistency when expectations are managed well and results match guidance. That said, elevated NCOs are not typically associated with a premium to peer-like valuation.
Source: SEC Filing
As one can see from the chart below, criticized loans continue to march higher. While not necessarily a bad thing in and of itself, I view the lack of reserve building that should coincide with this credit deterioration to be a continually building risk for the stock. Remember, not all criticized loans will be charged off, in fact, most will not. However, every loan that does get charged off the balance sheet causes the loan loss reserve level to fall. Remember, that reserve is that is standing between the bank's shareholder and financial loss.
Source: SEC Filing
Embedded within that sizable increase in criticized loans from the fourth quarter, more than $127 million of commercial loans were downgraded to address COVID-19 most at-risk lending exposures. While marking a loan criticized does help the bank with its credit options going forward, it is also an acknowledgment that the odds of being paid off in whole have fallen.
From a breakdown perspective, excluding PPP loans, retail loans (i.e. to individual retail businesses) make up $144 million of the entire lending portfolio, or 4.0% of the entire loan portfolio. Loans made to the building that houses a retail business make up $120 million (3.3% of the portfolio).
Outside of retail, hotel loans continue to remain elevated at $90 million (2.5%). Healthcare related loans actually increased from third quarter levels and now sit at $69 million (1.9%). Restaurants/Quick Service make up $32 million (0.9%), while entertainment and Oil & Gas loans remain fairly limited at $30 million and $9 million, receptively (0.8% and 0.2%).
When summing this entire list up, one will see that more than 13% of FISI's lending profile is directly made to the most "at risk" economic categories. In my mind, it will likely take a few quarter of economic growth, increased consumer spending, or additional loan loss reserve building in order to balance out the risk/reward skew of the recent credit deterioration.
When looking back, FISI's recent stock price increase makes a great deal of sense. From a macroeconomic perspective it was rather unlikely that this bank would be put out of business by overwhelming bad loans. It dipped as low as ~$14.50, which would have valued the stock at a little more than 0.6x P/TBV. At that valuation, overall survival would likely be somewhat of a looming concern.
That being said, the bank now currently trades for more than its tangible book value per share. While the recent stock price improvement might entice some to enter in hopes that its recent momentum will propel the stock higher, I think it likely treads water while its recent credit deterioration problems are addressed.
If the recent increase in criticized loans reverses course, and grinds lower, then share price improvement would likely be warranted. However, I find this to be rather unlikely given the rapid increase from the third quarter into the fourth.
In my mind, the most likely scenario is that the rate of growth slows dramatically and NCOs increase over the next couple quarters. Concurrently to this, the provision is likely to match all charge-offs which would help near-term profitability levels.
All told, FISI is a good bank that is experiencing some modest credit problems. Over the long-term it might be solid bank, I just think the next few quarters are a bit of gamble and investors should look elsewhere.
Source: SEC Filing and Author's Estimates
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